Role of central banks in an economy
The Central Bank is the ‘banker of banks’ that regulates the entire banking system and implements the monetary policy of a country. As the apex body of the banking and monetary system, the central bank has huge roles to play in an economy- such as the issue of currency, banker to the government, banker’s bank and supervisor, controller of money supply and credit, and custodian of foreign exchange reserves. All these functions of the central bank are aimed towards the overall economic development of a nation. Through its functions, it directly or indirectly affects the production process, employment rates, and economic growth.
As the currency authority, the central bank has the sole authority to issue currency in a country. Depending upon various factors and conditions of an economy, the central banks control the money supply and credit creation through various quantitative as well as qualitative instruments of credit control. One way through which money supply is influenced is- change in cash reserve ratio (CRR). CRR is the minimum percentage of total deposits that commercial banks are required to deposit with the central bank as cash reserves. An increase in the CRR leads to a reduction in credit creation as the commercial banks would now have fewer funds to extend credits, which absorbs excess liquidity from the market. Another tool is the discount rate (also known as bank rate), which refers to the rate at which the central bank lends money to commercial banks to meet their long-term needs. This directly affects the lending rates of the banks as a decrease in the discount rate will result in a decrease in the rate at which banks will lend money because a low discount rate allows commercial banks to borrow and lend cheaply. This encourages borrowers to take more loans which increases the credit-creating ability of commercial banks and ultimately increases the money supply in the economy. A similar effect can be witnessed through the use of the repo (repurchase) rate. Yet another tool used for this purpose is open market operations (OMO). OMO refers to the buying and selling of government securities by the central bank from and to the public and commercial banks. While the sale of securities by the central bank reduces the reserves of the commercial banks to decrease the money supply in the economy, the purchase of securities by the central bank increases the reserves of the commercial banks which help to inject money into the economy.
Apart from these functions, the central bank also acts as the banker, agent, and financial advisor of the government. As the 'banker of banks', the central bank functions as the custodian of cash reserves of the commercial banks and lender of the last resort- in case of financial emergency, the central bank lends money to commercial banks and takes necessary steps to revive the banking sector and the economy. And as a supervisor, it regulates and prevents commercial banks from becoming 'too big to fail'. The central banks also play an important role in the foreign exchange market and maintain the foreign exchange reserves of a country through adequate buying and selling of foreign currency.
With the ultimate aim of achieving economic growth, the central bank mainly focuses on stabilization of prices and economic fluctuations. Hence, in this era of globalisation, where economies are influenced by forces from all around the world, the role and importance of the central bank in any nation is indispensable.